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Teaching notes session 1


The term project finance is used loosely by academics, bankers and
journalists to describe a range of financing arrangements. Often referred in
trade journals and industry conferences as a new financing technique,
project finance is actually a centuries-old financing method that predates
corporate finance. However with the explosive growth in privately financed
infrastructure projects in the developing world, the technique is enjoying
renewed attention.
Navigating through History

Project financing techniques date back to at least 1299 A.D. when the English
Crown financed the exploration and the development of the Devon silver
mines by repaying the Florentine merchant bank, Frescobaldi, with output
from the mines. The Italian bankers held a one-year lease and mining
concession, i.e., they were entitled to as much silver as they could mine
during the year. In this example, the chief characteristic of the project
financing is the use of the projects output or assets to secure financing.
Another form of project finance was used to fund sailing ship voyages until
the 17th century. Investors would provide financing for trading expeditions on
a voyage to voyage basis. Upon return, the cargo and ships would be
liquidated and the proceeds of the voyage split amongst investors. An
individual investor then could decide whether or not to invest in the sailing
ships next voyage, or to put the capital to other uses. In this early example
the essential aspect of project financing is the finite life of the enterprise.
Project financing has evolved through the centuries into primarily a vehicle
for assembling a consortium of investors, lenders and other participants to
undertake infrastructure projects that would be too large for individual
investors to underwrite. The more prominent examples of the project
finance are:1. Road & bridges-Highways, Expressways and Seaways
2. Metro rails and other mass transit systems
3. Dams Multipurpose irrigation system
4. Railway network and services- both passenger and cargo
5. Power plants and other charged utilities- Solar power
6. Port and terminals
7. Airport and terminals
8. Mines and natural resource explorations, mineral processing
9. Pipelines and refineries
Large residential and commercial buildings
Large new industrial townships

Teaching notes session 1


There is no singular definition of project finance. In an article in the Harvard

Business Review, Wynant defined project finance as a financing of a major
independent capital investment that the sponsoring company has
segregated from its assets and general purpose obligations. A major
player in sponsoring infrastructure projects and providing financing in
developing countries, the World Bank defines project finance as the use of
nonrecourse or limited-recourse financing. Further defining these two
terms, the financing of a project is said to be nonrecourse when
lenders are repaid only from the cash flow generated by the project
or, in the event of complete failure, from the value of the projects
assets. Lenders may also have limited recourse to the assets of a
parent company sponsoring a project.
Critical features of project finance are:1. It is distinct legal entity known as SPV,
Project assets, project related contracts and project cash flows are
segregated ( kept separate) from sponsoring entity ,
3. Financed through limited recourse or non recourse basis,
4. Debt is typically secured by project's assets with
First priority on project cash flows is given to the lender
Covenants like lenders consent to disburse any surplus cash flows to project
sponsors are added
Higher risk projects may required the surety/guarantee of project sponsors
( known as limited recourse financing)

Project finance Vs Corporate Finance

Project Finance is different from conventional direct financing as illustrated below:

Project finance
Special purpose vehicle facilitate
assets securitization
Highly leveraged

Corporate finance
secured debts

Board members taken from

various stake holders/risk takers
within overall SEBI rules

Large public firms have to

satisfy rules laid down by SEBI
for independent directors
Normal covenants


Teaching notes session 1


greater disclosure
Soundness of project cash flow
and risk assessment

Security backed financing

Special characteristics of project financing

Capital-intensive- Project financings tend to be large-scale projects that

require a great
deal of debt and equity capital, from hundreds of millions to billions of
dollars. Infrastructure projects tend to fill this category. A World Bank study
found that the value of investment brought by project finance EUR 300 billion
Highly leveraged- These transactions tend to be highly leveraged with
debt accounting for usually up to 80% of capital in relatively normal cases.
Long term- The tenor for project financings can easily reach 15 to 20 years.
Independent entity with a finite life - Similar to the ancient voyage-tovoyage financings, contemporary project financings frequently rely on a
newly established legal entity, known as the project company, which has the
sole purpose of executing the project and which has a finite life so it cannot
outlive its original purpose. In many cases the clearly defined conclusion of
the project is the transfer of the project assets. For example, in a buildoperate-transfer (BOT) project, the project company ceases to exist after the
project assets are transferred to the local company.
Non-recourse or limited recourse financing- The project company is the
borrower. Since these newly formed entities do not have their own credit or
operating histories, it is necessary for lenders to focus on the specific
projects cash flows. That is, the financing is not primarily dependent on the
credit support of the sponsors or the value of the physical assets involved.
Thus, it takes an entirely different credit evaluation or investment decision
process to determine the potential risks and rewards of a project financing as
opposed to a corporate financing. In the former, lenders place a substantial
degree of reliance on the performance of the project itself. As a result, they
will concern themselves closely with the feasibility of the project and its
sensitivity to the impact of potentially adverse factors. Lenders must work
with engineers to determine the technical and economic feasibility of the
project. From the project sponsors perspective, the advantage of project
finance is that it represents a source of off-balance sheet financing.
Controlled dividend policy- To support a borrower without a credit history
in a highly-leveraged project with significant debt service obligations, lenders

Teaching notes session 1

demand receiving cash flows from the project as they are generated. This
aspect of project finance recalls the Devon silver mine example, where the
merchant bank had complete access to the mines output for one year. In
more modern major corporate finance parlance, the project has a strictly
controlled dividend policy, though there are exceptions because the
dividends are subordinated to the loan payments. The projects income goes
to servicing the debt, covering operating expenses and generating a return
on the investors equity. This arrangement is usually contractually binding.
Thus, the reinvestment decision is removed from managements hands.
Many participantsThese transactions frequently demand
participation of numerous national as well as international participants.


Allocated risk- Because many risks are present in such transactions, often
the crucial element required to make the project go forward is the proper
allocation of risk. This allocation is achieved and codified in the contractual
arrangements between the project company and the other participants. The
goal of this process is to match risks and corresponding returns to the parties
most capable of successfully managing them. For example, fixed-price,
turnkey contracts for construction which typically include severe penalties for
delays put the construction risk on the contractor instead on the project.
Costly - Raising capital through project finance is generally more costly
than through typical corporate finance avenues. The greater need for
information, monitoring and contractual agreements increases the
transaction costs. Furthermore, the highly-specific nature of the financial
structures also entails higher costs and can reduce the liquidity of the
projects debt. Margins for project financings also often include premiums for
country and political risks since so many of the projects are in relatively high
risk countries. Or the cost of political risk insurance is factored into overall
Project finance: when and why?
Given the aforesaid discussion the advantages of project finance as a
financing mechanism are:1. It can raise larger amounts of long-term foreign equity and debt
capital for a project.
2. It protects the project sponsors balance sheet. Through properly
allocating risk, it allows a sponsor to undertake a project with more
risk than the sponsor is willing to underwrite independently.
3. It applies strong discipline to the contracting process and operations
through proper risk allocation and private sector participation.
4. The process also applies tough scrutiny on capital investment

Teaching notes session 1

5. By involving numerous international players including the
multilateral institutions, it can provide a kind of de facto political
6. Investors rather than managers get to make the decisions about
reinvesting surplus cash flows from the project.
On the other hand, the financing technique also presents certain
disadvantages which are:1. It is a complex financing mechanism that can require significant lead
2. High transaction costs are involved in developing these one-of-a-kinds,
special-purpose vehicles.
3. The projects have high cash flow requirements and elevated coverage
4. The contractual arrangements often prescribe intrusive supervision of
the management and operations that are usually resented in a
corporate finance environment.